China's export success has not only financed real sector growth but spawned asset bubbles that could trigger a financial crash.
CHINA'S economic predicament today is unenviable. Its problem is not that it is experiencing slow growth or is faced with recession, but that it has grown too fast for too long. Its difficulty is not that it is strapped for foreign exchange, but that it has an embarrassing surplus of foreign exchange reserves exceeding a trillion dollars in value. Its concern is that the export success that had won China the world's admiration is widening its trade surplus far too much for comfort.
The paradoxical problem of excessively high, externally driven growth was flagged mid-April when China's National Bureau of Statistics announced that growth during the first quarter of 2007 had touched 11.1 per cent relative to the corresponding period of the previous year, up by 0.7 percentage points, when compared with the last quarter of 2006. The announcement triggered panic selling in the Shanghai stock market, resulting in a 4.5 per cent drop in the Shanghai Composite Index. Coming in the wake of a 9 per cent decline on February 27, 2007, this "correction" of an index widely held to be overvalued indicates that the perception is that Chinese growth must slow.
The reason for that perception is only partly inflation. It is indeed true that an inflation rate (as measured by the Consumer Price Index) of 3.3 per cent in March, driven by a 6.2 per cent increase in food prices, is seen by the Chinese central bank and the Chinese government as a bit too high for comfort. But inflation rates of this magnitude are low by global standards, especially when placed in the context of China's consistently high growth.
The explanation for expectation of a slowdown in growth must therefore lie elsewhere. One source from which such expectations derive is the fact that China's exchange rate is under pressure to appreciate. Large foreign exchange reserves and a rising trade surplus, combined with large inflows of foreign capital, are a sure-fire recipe for exchange rate appreciation. China had for long been managing its exchange rate, keeping it pegged to the dollar. But after pressure to undo the peg forced the Chinese government to loosen the fixed link between the renminbi yuan and the dollar, the yuan has appreciated by as much as 6.7 per cent (from 8.2765 yuan to the dollar to 7.7211) between late-June 2005 and April 27, 2007.
Though this is a minor appreciation given the depreciation of the dollar vis--vis most world currencies, it has implications for two reasons. First, once the process of appreciation has begun, preventing further appreciation of the yuan becomes difficult given the fact that China's rising trade surplus is the focus of the world's attention. China's trade surplus for the first two months of this year was about $40 billion, which would have taken it to $240-250 billion for the whole year. However, there are signs that the appreciation of the yuan is having some effect. We must recall that China's trade surplus tripled in 2005 to $102 billion, but rose by only 74 per cent in 2006. Moreover, on April 12, the People's Daily reported that China's trade surplus was merely $6.9 billion in March 2007, reflecting a 38 per cent fall on a year-on-year basis and a 70 per cent decline from a surplus of $2.4 billion in February. The March figure represented a 13-month low. What is noteworthy is that the decline in the trade surplus was not the result of a rise in imports, which stood at $83.43 billion in March, a rise of only 6.9 per cent year-on-year.
These signs of a shrinking trade surplus bring us to the second reason why the effects of the appreciation of the Chinese currency trigger expectations of a slowdown. This is because of China's heavy dependence on the U.S. market. According to the International Monetary Fund's Direction of Trade Statistics, China's exports to the U.S. accounted for more than a fifth of its exports to the world as a whole and two-fifths of its exports to industrial countries. If appreciation of the yuan vis--vis the dollar continues, adversely affecting the country's competitiveness in U.S. markets, export growth can decelerate further, slowing China's growth.
But, besides the effects of an appreciating exchange rate, the threat to real sector growth in China is financial. China's economic success generates and feeds on a huge expansion in money supply and credit that results from its rapidly increasing reserves of foreign exchange. Those reserves are the inevitable corollary of the Chinese government's efforts to moderate appreciation of the yuan by buying out a large part of the foreign funds flowing into the country.
As a leader in the Financial Times (January 12, 2007) put it: "The market intervention needed to hold the renminbi down boosts domestic liquidity, fuelling asset price bubbles and greatly complicating the task of economic management." The danger is that the expansion in credit that fuels real growth is fuelling speculative real estate and stock market investments that could unwind and generate a crash.
There is reason to believe that credit-financed investment spurs real growth in China. The investment rate in China (investment as a share of gross domestic product) has fluctuated between 35 and 44 per cent over the past 25 years, and has ruled well over 40 per cent in most recent years. However, what is interesting is the high share of real estate development in the total, amounting to 17-19 per cent in the first five years of this decade. This category includes real estate development by central and local government bodies as well as investment in residential construction. The former includes investment in economic development zones and what have come to be referred to as "image projects" launched by local leaders to beef up their public stature. The latter includes a substantial amount of private residential construction that is under way, especially in urban China, in the wake of relaxation of laws governing residential property ownership.
It should be expected that the relaxation of residential property ownership rules must have resulted in the conversion of savings accumulated in the past into investment in residential property. This spurt, together with the high degree of volatility of local government development expenditures, has made real estate development the most volatile part of fixed assets formation. According to economist Yongding Yu of the Chinese Academy of Social Sciences, during the early 1990s, the growth rate of investment in real estate "varied between 11.7 and -1.2 per cent".
This kind of volatility is partly facilitated by the manner in which capital formation is financed in China. Budgetary appropriations and foreign investment account for small shares of between 8.6 and 11.7 per cent of total fixed assets formation during 2001-2005.
The major finance comes from three sources, all of which involve a substantial degree of borrowing: domestic loans (17.3 to 20.6 per cent) and raised funds and others (70-74 per cent). Domestic loans refer to loans of various forms borrowed by investing units from banks and non-bank financial institutions. "Raised" funds refer to extra-budgetary funds received by investing units from Central government Ministries, local governments, enterprises and institutions for investment in fixed assets.
And "other funds" refers to funds for investment in fixed assets received from sources other than those listed above, including capital raised through issuing bonds by enterprises or financial institutions, funds raised from individuals, and funds transferred from other units. All of these involve some degree of direct or off-budget borrowing.
It is not surprising therefore that excess liquidity created by China's burgeoning foreign exchange reserves is resulting in a credit-financed investment and real estate boom. For instance, the annual rates of growth of property prices stood at 15.1 per cent and 19.5 per cent in 2004 and 2005. The evidence suggests that bank lending played an important role in this increase in property prices. The credit exposure of commercial banks to the property and property-related sectors increased from just 3.6 per cent in 1998 to 14.8 per cent in 2004 and the mortgage loan to total loan ratio increased from only 0.59 per cent in 1998 to 8.88 per cent in 2005 (Qi Liang and Hua Cao, Journal of Asian Economics, 2007).
Faced with this credit-financed speculative boom in the property market, last August China's Banking Regulatory Commission (CBRC) announced policies aimed at tightening bank credit to the real estate sector. Principally, financial institutions were barred from granting loans to property development projects whose developers fail to raise 35 per cent of the investment from their own resources. The policy also tightened lending to developers suspected of hoarding land and property.
With respect to personal housing mortgage loans, the new policy required banks to decide on down payments by borrowers on the basis of their credit worthiness rather than some unified standard. The move was a clear indication that the government was concerned about commercial banks falling victim to a real estate bubble gone bust. If that were to occur, a liquidity crunch could ensue, slowing growth sharply.
Overall, efforts are on to slow down credit growth by raising reserve requirements and hiking interest rates. Most recently, on April 29, 2007, the People's Bank of China hiked the reserve requirement of commercial banks by 50 basis points, to 11 per cent. This increase in the stipulated reserve ratio is the fourth announced by the central bank this year and the seventh since last June. The central bank has also increased interest rates three times in the past year.
To the chagrin of the central bank, this has not put the brakes on credit growth. Chinese banks are reported to have extended new loans to the tune of 1.5 trillion yuan ($186.6 billion) in the first quarter of this year, which was more or less equal to the loans advanced over seven months from June through December last year.
Credit growth of this kind also seems to underlie stock market volatility. During one week in April, Chinese retail investors opened more than 1 million new accounts, taking the total for the previous four months to more than 10 million, or more than that seen during the previous four years combined. Not surprisingly, the Financial Times reports that the Shanghai stock index has been ruling nearly 40 per cent higher so far this year, on top of a 130 per cent increase last year.
Retail investors began swarming into the stock market in May last year, after an almost five-year bear run. Part of the reason was a boom in the market that attracted Chinese households and corporations holding $4.5 trillion in bank deposits earning less than 3 per cent per annum. At the current rate of inflation these depositors were earning negative real returns, which attracted them to the stock market.
This, of course, implies that if the stock bubble unwinds, many innocents would burn their fingers. Not surprisingly, China's policy-makers are concerned that cheap and easy liquidity is fuelling the boom in the domestic stock market. But the fear remains that any drastic correction could unwind investments too fast, leading to a crash. The two sharp downturns in the market have only enhanced those fears.
In sum, the danger today is that the liquidity built up by China's external success has not only financed real sector growth but spawned asset bubbles that could trigger a financial crash. Together with the effects of the inevitable yuan appreciation, this could set off China's next growth slowdown.